An Interview With Michael Raynor

A director at Deloitte Services LP and coauthor of The Three Rules: How Exceptional Companies Think, Michael Raynor joins the Fool to share his findings about what makes a company successful for the long haul.

In this interview, we examine the three rules followed by exceptional companies from Merck to Abercrombie & Fitch , why they work, and what investors might be able to take away from the analysis.

A full transcript follows the video.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of the last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

Brendan Byrnes: Hi, folks, I'm Brendan Byrnes and I'm joined today by Michael Raynor. Michael is the coauthor of The Three Rules: How Exceptional Companies Think. First of all, thanks so much for your time.

Michael Raynor: It's a pleasure to be here.

Brendan: Obviously, there are tens of thousands of companies out there. How do you narrow it down and look for these exceptional companies, and how many exceptional companies did you find?

Michael: Sure. We looked at a database that covered 45 years of data, 25,000 companies or more, 300,000 company-year observations, so an enormous quantity of data. The only way you sift through that is with some pretty high-powered statistics.

We were able to separate the signal from the noise, identify those companies that had been good enough for long enough that we could be pretty confident we had more than just lucky random walkers on our hands. That's why we used the term "exceptional;" companies that really rose above the noise.

Brendan: How many companies did that wind up being, in the end, that you focused on in the book -- 27, I think?

Michael: Well, 27 case studies. We were, however, able to identify the full population of exceptional companies. There are 174 of what we call "Miracle Workers" -- the very best of the best -- and 170 "Long Runners."

That's the full population of all the exceptional companies that have really ever existed, if you will, as publicly traded entities in the U.S. over that 45-year period.

Brendan: Could you walk us through some of the metrics that you used specifically, in identifying those? Also, that's very quantitatively focused. What about qualitative aspects? How do you incorporate that? A company's brand, for example, competitive advantage ... intangible assets, how do you incorporate those?

Michael: Sure. Well, we kept it pretty simple when it came to measuring performance. We focused on profitability, as measured by return on assets.

There are other measures of company performance, of course. No measure captures everything, but if you accept the fact that profitability is an important measure, then we have something potentially useful to say.

We were able to do some statistical analysis on that population of exceptional companies and get a general feel for the financial shape, if you will, of their performance advantage, but then we had to look under the hood.

We did some in-depth, very detailed case studies on the 27 companies in total, 18 of which were exceptional. We had nine trios: a Miracle Worker, a Long Runner, and then what we called an Average Joe; a company that had average performance, average volatility, average lifespan.

Brendan: Could you walk us through the three rules that separated these exceptional companies from the pack?

Michael: Absolutely. It was a bit of a journey to get there, because we originally started out trying to understand the behaviors that made the difference. Was it M&A? Was it diversification? Was it focus? Was it innovation? None of those things were systematically related.

What we landed on were these three rules; essentially, decision-making principles that were implied by the actions that these companies took, over time. There were three.

The first of them is, "Better Before Cheaper." When it comes to how a company creates value for its customers, differentiate yourself based on being better than the competition, not being cheaper than the competition.

But creating value's not enough. You have to capture some for yourself, in the form of profits. There, it's "Revenue Before Cost."

We think that's important, because you can drive profitability any way you want. Math doesn't care, but reality does. Companies that deliver exceptional performance systematically focus on building revenue through either price or volume, and they tend not to have cost advantages, which was a bit of a surprise.

Then finally the third rule, "There Are No Other Rules." The reason we think that's important is that it's really easy to fall into the trap of thinking, "There must be something about leadership. There must be something about culture. There must be something" about all these other things that we know matter, but that don't appear to matter in a systematic way.

The third rule says, "Change anything you have to, in order to hew to Rule 1 and Rule 2."

Brendan: If an investor is looking at your book and saying, "How do I go over that methodology? How do I look at companies this way?" what would you say to them when they're trying to evaluate a company?

Michael: That's a great question.

First of all, I'd say that our work is fundamental in nature. We're looking at company fundamentals and we try to understand companies that are great companies, rather than necessarily identifying companies that are going to be great investments.

Now, it does turn out, however, that companies that deliver superior profitability tend to have better total returns to shareholders than companies that don't deliver superior profitability. Being an adherent to the three rules, as far as our data are concerned, suggests good things for equity holders.

Brendan: I think you mentioned there are 18 companies in that upper echelon that you found. What's the one that impressed you the most?

Michael: That's an interesting question. I hadn't really thought about the "top of the Pops." I think they all impressed me in very different ways because they all had their own unique formula for delivering exceptional performance.

Again, that's why rule number three is There Are No Other Rules. It's all about being better and driving revenue. In a sense, every company's got the same recipe but fundamentally different ingredients. It was the uniqueness of every one of them that I found so impressive and, frankly, so surprising.

Brendan: Could you maybe walk us through a few examples of specific companies amid those 18?

Michael: Sure. We have three categories of Miracle Workers. I'll give you one of each.

In our "Kept It" category -- these are companies that have been consistently miracle workers over their entire observed lifespan -- Abercrombie & Fitch is one that has really impressed us with their ability to adhere to those two rules, really through thick and thin, sometimes taking a lot of heat for it from the investor community, but sticking to their guns in ways that we find pretty impressive.

There are "Lost It" Miracle Workers; companies that were great for a while but then kind of came off the rails. A company like Maytag, for example, would fall into that category. They spent 20 years, from the middle '60s to the middle '80s -- one of the longest streaks of superior performance in our entire database -- but then really came off the rails, kind of lost their way, were unable to stay close to the rules.

They were acquired by Whirlpool , ultimately. Curiously, a lot of what you see Whirlpool doing with the Maytag brand looks suspiciously close to following the rules again, so that's promising, at least in our view.

Then finally, "Found It" Miracle Workers; companies that bounced around for a while kind of like wayward teenagers, and then found their way. A company like Linear Technology , for example, a semiconductor manufacturer, would fall into that category. It started out as a second source supplier for the USDOD, now makes a vast array of highly customized, very highly differentiated analog microprocessors.

Again, enormous diversity, but what ties them all together, Better Before Cheaper and Revenue Before Cost.

Brendan: I wanted to ask you specifically about Abercrombie & Fitch, which you say is an exceptional company. I think this might surprise some people, especially when they see the recent comments of the CEO, taking the extra-large and extra-extra-large clothes off the shelf.

Also their earnings; they had fewer earnings last year than they did in, I think, the stretch from 2006 to 2009. Could you maybe go through the process that landed them on the list, and the things that you evaluate with them?

Michael: Yeah. There are a couple of things worth pointing out; first of all, we're looking at company lifetime, so when I talk about Abercrombie & Fitch, we're talking about it from 1996 through to today.

The other thing is that the statistical methods that we use are actually pretty immune to the ups and downs of the market. We tend not to get too hung up on what's been happening not only in the last two or three quarters, but even the last two or three years.

That takes a little getting used to, especially in an industry like retail, where if I said to you, "You really have to understand the last 10 years in order to understand your performance," some people would look at me ... they'd kind of squint a bit. But we feel we have good reason for looking at it that way.

I guess the last thing to point out is that when it comes to the specific choices that get made, well that's kind of why we play the game. The rules, we think are very helpful, but they're not a road map. They don't prescribe precisely what you need to do to be successful. They indicate which hard problem you should try and solve.

When we look at the Miracle Workers that stay there, they stay focused on those hard problems even if they have speed bumps or hiccups along the way.

Brendan: How do you think we extrapolate this forward? Obviously the data is backward-looking ...

Michael: All data are.

Brendan: Right, so how do we ensure that the data ... maybe a company was great in the past. How do we ensure that they stay great in the future?

Michael: Well, the hope is that's where the rules come in handy. They're a compass. They point. They say, "The great performance lies that way."

Companies that remain focused on moving in that direction, those are the companies that we feel will have the best chance of continuing or creating a run of exceptional performance.

Brendan: Right. Whole Foods is another company that you point out as an exceptional company. They recently had...

Michael: Actually, they're the Average Joe of the trio.

Brendan: Average Joe, are they? I'm sorry.

Michael: Yes.

Brendan: They had their stock split, though, and I think you said that might be a positive for Whole Foods. Why?

Michael: Again, there's a difference between a great company and a great investment. What I would say about Whole Foods, I guess, is if we look at their performance over their whole lifespan, their profitability has been unexceptional.

But of late -- and "of late" in our world means the last three, four, five years; not the last two or three quarters -- they've really been on a tear.

They're absolute and relative performance has been increasing dramatically and without, I should point out, abandoning the rules. They've always been a highly differentiated player, focused on Better Before Cheaper, driving up profitability through pricing premiums, typically, to their nearest competitors.

I think what you see in their improvements of late is a fine tuning and finding the right balance among those different variables. I think that the increases that you've seen -- if you'll forgive me -- are entirely consistent with what we would have expected.

Brendan: Right. I think one of the biggest things with Whole Foods, you could argue, is their strong culture. They pay their employees more, as their recent success, I think they're up something like 800% since early 2009.

We talked about this earlier, but how do you incorporate culture into this? Obviously you don't have a data point in it. Do you just assume that that's incorporated in some of the data points that you do have?

Michael: Well, we looked at things like culture insofar as it's possible to operationalize that or measure it. Really, again, that's why the third rule is There Are No Other Rules, because culture is critically important, and a lot of people would agree with you, I think, that culture is critically important in a place like Whole Foods.

I've got examples where culture didn't seem to matter much at all, so hard to draw any rules, any trends, any systematic pattern in terms of why culture is important or the ways in which it is important.

That's why we've really only got those first two. That's as far as the data would let us go.

Brendan: Let's talk about the pharmaceutical industry. You mentioned Merck as one of the top companies there. What is Merck doing better than a Pfizer or a Johnson & Johnson , one of those companies?

Michael: Well, again, we're looking at 45 years of data with a company like Merck. The company that we compared it to directly was Eli Lilly , another company for which we have a full 45 years of data.

Curiously, there, what we found is that they both have very strong non-price positions. They both are rooted in great science. They make highly effective, highly differentiated therapies for diseases that afflict a lot of people, and they create a lot of value as a consequence.

That's not what differentiated them. What differentiated them was Rule 2, which was Revenue Before Cost; the way in which they were able to drive superior profitability.

Merck was able to both globalize its customer base, and also introduce a much broader array of products more rapidly than Eli Lilly was, and as a consequence drove much of its superior profitability as a result of asset turns born of superior volume, but -- and this is the kicker -- superior volume born of its differentiation.

Econ 101 will tell you, if you want to increase volume you've got to cut price. That's not what they did. They're Better Before Cheaper. They drove their volume through differentiation, and that's what led to their superior profitability.

Brendan:JCPenney is a company that's obviously been struggling lately. Could we talk about, in your framework, how they fit in and what rules they're following and not following? What do you think?

Michael: Yeah. I guess I'd have to say that's one where I just don't have enough information to have an opinion, I'm afraid. There's a lot of companies out there. Can't know them all.

Brendan: Not a problem at all. What about the surprising amount of dollar store companies that are public? You have Family Dollar , Dollar Tree , Dollar General . You mention, in particular, Family Dollar which is the lowest market cap out of all of those, as doing the best, an exceptional company. Why?

Michael: Great example there. It's a Miracle Worker. They've had extraordinarily high profitability for an extraordinarily long period of time. We compared them there to some of the giants of the discount retail sector.

They've enjoyed material profitability advantages and, curiously enough, for reasons that I would think are consistent with the rules. When you look at their model, they don't build 100,000 square-foot superstores in the exurbs. They have tended -- and I'm talking about, again, the last 30-40 years -- they have tended to build much smaller stores, closer to urban centers.

They are a higher-cost operation, by and large. They have lower asset turns than other discount retailers, but they get paid for it. They break bulk profitably, so they have in fact the kinds of pricing premiums -- even in discount retail, for crying out loud, I want to say -- in ways that drive their superior profitability.

That one really surprised us, because if we were going to find an exception, we would have thought we'd have found it there. But we didn't.

Brendan: What do you think is the big takeaway from the book? What do you want people to learn after reading?

Michael: I guess, first of all, just those rules; that these are ways of thinking about hard choices. They are ways of identifying in which direction you want to be moving consistently over time, using the rules to help you make difficult decisions in the face of ambiguous data.

I think we have this mythology, somehow, that if we collect enough data and analyze it enough, the right answer will invariably fall out, and the world just doesn't work that way. There is inevitable and inescapable ambiguity.

Some people think that decision-making biases are a bad thing. In the face of ambiguity, the only way you can make a decision is if you have a bias. What our data show, I think, is "Here are the right biases to have."

When you're making choices about how to create value, Better Before Cheaper. When you're making choices about how to drive profit, Revenue Before Cost.

Brendan: Michael Raynor, coauthor of The Three Rules: How Exceptional Companies Think. Thanks so much for your time.

Michael: It's been great. Thank you.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of the last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

Brendan Byrne has no position in any stocks mentioned. The Motley Fool recommends Linear Technology. It recommends and owns shares of Johnson & Johnson and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.